Fund of Funds

How it Works

Fund of hedge funds strategy, also known as a collective investment or multi-manager investment, enables hedge fund managers to construct a diversified portfolio of different investment funds. In fact, hedge fund managers allocate their capital over individual funds that incur different risk and offer different exposure to the market depending on the investor profile and individual risk tolerance.

The Details

Instead of investing in a single fund, the fund of hedge funds strategy invests directly into different funds. Fund managers use different management strategies (multi-strategy fund) or the same management strategy (single-strategy fund). The multi-strategy fund invests in 20 to 30 different hedge funds, typically using the equity long/short, convertible bond arbitrage, statistical arbitrage, and merger arbitrage strategies. The fund manager is able to change the allocation of capital as the market condition change. A single-strategy fund, typically, invests in no more than three different funds. The funds are locked up for a given time period, providing diversified exposure while leveraging risk. Furthermore, fund of hedge funds strategy requires a lower minimum initial investment compared to most hedge funds. However, because it comes with an added level of management, it incurs higher fees.

The Fundamentals

The fund of hedge funds strategy offers active management and diversification, seeking for growth and high returns. Although it achieves lower returns than stocks, it gains exposure to less volatility through geographic and sectoral dispersion. Hedge fund managers select the underlying funds based on historical performance, seeking to increase returns through optimum diversified portfolios.

The Upside

The fund of hedge funds strategy enables investors to obtain immediate diversification by investing in portfolios that are large enough to invest in different hedge funds, but small to achieve optimum diversification by investing in a single hedge fund. Furthermore, the fund of hedge funds strategy requires a low initial minimum investment. Given that the initial investment in a hedge fund is usually $1,000,000, an investor with $3,000,000 can only invest in three separate funds, but he cannot achieve the diversification that a single-strategy fund or a multi-strategy fund offer. Conversely, by investing in a fund of hedge funds strategy, he pays $1,000,000 and constructs a diversified portfolio of 20 different hedge funds, thus gaining exposure to different asset classes without compromising his portfolio. Furthermore, a multi-strategy fund delivers consistently positive returns, which are not correlated to the movements in the interest rates or the currency market. Therefore, a multi-strategy fund incurs a lower risk than the equity market, has lower volatility, and achieves high returns.

The Risk

Investing in a fund of hedge funds incurs higher fees than any other hedge fund strategy. Besides the normal fees charged by any hedge fund, the fund of hedge funds strategy charges incremental fees, including a fee for active management of 1% to 2%, and an incentive fee of 15% to 30% on the returns generated. Furthermore, the success of the multi-strategy fund depends on the skills and the insight of the hedge fund manager. The fund manager has to select the proper hedge funds that match the investor profile and determine the proper strategies that can offer broader diversification and higher returns depending on the current market conditions. He should also monitor the market and adjust the hedge fund strategies accordingly. However, active management usually incurs the risk of a wrong investment decision that can compromise the entire portfolio.

The Bottom Line

Fund of hedge funds strategy capitalizes on the skills of the hedge fund manager and his ability to select the appropriate underlying funds to achieve diversification and optimum returns. The strategy offers great upside potential if the management is effective enough to leverage the investment risk and increase the returns capitalizing on portfolio diversification. Furthermore, the fund of hedge funds strategy offers the option to invest in multiple funds, thus avoiding to compromise the portfolio.

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